Europe faces an impossible challenge - why can't Olli Rehn see it?

"There is no alternative". That was again the message this weekend
from our old friend Olli Rehn in telling Der Spiegel that the eurozone's
miscreant periphery has no option but to stick to the assigned path of
budgetary consolidation.

Mr Rehn should no longer be taken seriously, but he can at least be congratulated on his entertainment value. He'd have been out on his ear long ago if he were in any way democratically accountable to the nations he dishes it out to, but of course his position allows him to float serenely above all such unpleasantness.Photo: EPA

With Italy in open political revolt and much of the rest of the Club Med deep in the grips of an apparently inescapable depression, there is, he said, no room for manoeuvre. Normally when something isn't working, you try a different approach, but the luckless European economics chief finds himself so locked into the task of defending the indefensible – the single currency - that he is unable to offer alternatives.

I say "old friend" because Mr Rehn's rigid adherence to the script has become an almost comically blinkered form of dogma, rendering him more a subject for mockery and ridicule than the feared enforcer he is supposed to be.

As I have said before, he can scarcely believe in what he is preaching, but a more loyal spokesman for the cause of fiscal austerity would be hard to find. Just recently, he described debate about the sanity of Europe's approach to economic policy as "unhelpful", as if to say that discussion of alternatives is no longer allowed. He also keeps on saying the worst of the crisis is behind us, only repeatedly to be proved wrong.

Mr Rehn should no longer be taken seriously, but he can at least be congratulated on his entertainment value. He'd have been out on his ear long ago if he were in any way democratically accountable to the nations he dishes it out to, but of course his position allows him to float serenely above all such unpleasantness.

In any case, the problem is not austerity as such, but the attempt to cram fiscally different nations with widely divergent competitiveness into a single currency area. Austerity is just the chosen response to a flawed endeavour.

That the medicine prescribed is beginning to threaten the institutions of democracy seems to be regarded as irrelevant to the greater good of keeping the dream alive.

In a new analysis of the scale of the challenge, the Ifo Institute's European Economic Advisory Group (EEAG) points out that the eurozone crisis is in fact three different crises rolled into one; the sovereign debt and banking crises are, in effect, mere symptoms of an underlying problem of divergent competitiveness which has resulted in an unreconciled, good old-fashioned balance of payments crisis.

Normally, trade and capital imbalances of the sort that have been allowed to build up in the eurozone are corrected through exchange rate adjustment, but of course that cannot happen in a single currency area.

These imbalances were first financed through bank lending from the core, surplus countries, which were, in effect, lending the deficit countries the money to buy their goods. When the banking crisis caused this deficit financing to dry up, the weaker nations were left instead to fall back on public support from European bailout funds and the European Central Bank.

The EEAG analysis details three possible solutions to this predicament, and there really are only three without going the whole hog of fiscal and political union. One is exit and external devaluation for deficit countries. A second is internal devaluation through falling prices and wages in deficit nations. And a third is internal devaluation through rising prices in the core.

It is the second of these two options that eurozone policymakers such as Mr Rehn have opted for. Exit for one or more of the weakest nations has been ruled out for fear of the contagion it might generate. Strongly rising prices in the core is also rejected on account of the damage it would do to savers. In effect, their wealth would be devalued, an impossible ask for Angela Merkel to sell to her voters.

Analysis by Goldman Sachs has suggested that Germany would need to suffer an inflation rate 4pc higher than the periphery for a period of 10 to 15 years to achieve such a revaluation and eradicate the imbalances.

This would imply a 40pc decline in German wealth, all other things being equal. No nation, however altruistic, is willingly going to take such a hit. That leaves the periphery having to assume all the burden of the adjustment. Goldman Sachs estimates that a 35pc internal devaluation would be required to return Portugal to competitiveness, 30 per cent by Greece and 20 per cent by Spain. Italy requires a 10-15pc adjustment.

The example of the Baltic states - forced to enact even bigger internal devaluations to sustain their euro pegs - shows that it can be done, but these are tiny former Soviet satellites which had gigantic pre-crisis booms and have in any case been able to export a good part of their unemployment problem.

Major advanced economies are a different kettle of fish. Italy had no pre-crisis boom, yet it is being asked to tolerate punishing levels of deflation which have already taken output back more than a decade to where it was in the 1990s before the euro even existed.

Prices and wages have in practice proved quite sticky. They are not easily cut, with the result that the bulk of the adjustment has instead come from rising unemployment. Eurozone policy makers tend to point to shrinking current account deficits and declining unit labour costs as evidence that the policy is working. They are wrong. The underlying causes of this rebalancing are collapsing internal demand on the one hand and rising unemployment on the other. If that counts as success then the eurozone truly is on the road to madness.

There's a further problem with shrinking the economy back to apparent competitiveness. Unfortunately, it makes the fiscal position worse, not better. Nominal debt will remain the same even as the economy contracts, so as a proportion of GDP, it gets bigger still. The policy therefore offers no route back to fiscal sustainability.

The more the eurozone struggles to adapt, the worse it gets. It used to be said that one of the reasons Europe would struggle to maintain monetary union was that unlike the United States, it didn't have the necessary labour mobility to act as a pressure valve.

Analysis by Marcel Alexandrovich, of the investment bank Jefferies, shows that actually this has changed quite radically since the crisis began, with quite strong levels of labour migration from the deficit to the surplus countries. Regrettably, this makes the challenge of fiscal retrenchment in the weaker nations even greater, for the migration has hollowed out the weaker countries of tax-paying talent. A falling population lowers the trend rate of growth, so it also increases the proportion of the deficit that must be seen as structural. Some degree of debt and fiscal federalism would remove these distortions, but for now, that's not remotely on the agenda, nor is there any appetite for it even in the deficit nations, let alone the ones that will ultimately foot the bill.

Is Mr Rehn a fool or a knave? Either way, history will not judge him kindly.